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Estimating Inputs for Valuation|Views: 8|Likes: 0

Publicado porAvinash Kharde

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https://pt.scribd.com/doc/44829574/Estimating-Inputs-for-Valuation

07/11/2013

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Errors in estimating the discount rate or mismatching cashflows and discount rates can lead to serious errors in valuation. * At an intutive level, the discount rate used should be consistent with both the riskiness and the type of cashflow being discounted. I. Cost of Equity The cost of equity is the rate of return that investors require to make an equity investment in a firm. There are two approaches to estimating the cost of equity; * a risk and return model * a dividend-growth model. Models of Risk and Return The Capital Asset Pricing Model * Measures risk in terms on non-diversifiable variance * Relates expected returns to this risk measure. * It is based upon several assumptions (a) that investors have homogeneous expectations about asset returns and variances (b) that they can borrow and lend at a riskfree rate (c) that all assets are marketable and perfectly divisible (d) that there are no transactions costs and that there are no restrictions on short sales. Risk in the CAPM Beta: The non-diversifiable risk for any asset can be measured by the covariance of its returns with returns on a market index, which is defined to be the asset's beta. The cost of equity will be the required return, Cost of Equity = Rf + Equity Beta * (E(Rm) - Rf) where,

Rf = Riskfree rate E(Rm) = Expected Return on the Market Index Using the Capital Asset Pricing Model * Inputs required to use the CAPM (a) the current risk-free rate (b) the expected return on the market index and (c) the beta of the asset being analyzed. Practical issues in using the CAPM -1. Measurement of the risk premium * It is generally based upon historical data, and the premium is defined to be the difference between average returns on stocks and average returns on riskfree securities over the measurement period. Magnitude of the risk premium Historical Period 1926-1990 1962-1990 1981-1990 Stocks - T. Bills Arithmetic 8.41% 4.10% 6.05% Geometric 6.41% 2.95% 5.38% Stocks - T.Bonds Arithmetic 7.24% 3.92% 0.13% Geometric 5.50% 3.25% 0.19%

*** Generally, geometric averages provide better estimates of risk premiums in valuation.
**

y

The risk premiums will vary across markets, depending upon their riskiness. While historical data can be used to estimate premiums outside the United States, it is not very reliable. An alternative way of estimating premiums is to use country bond ratings to estimate these premiums relative to the U.S. premium. For instance, the risk premiums for South American countries can be estimated as follows: Rating BBB BB Risk Premium 5.5% + 1.75% = 7.25% 5.5% + 2% = 7.5%

Country Argentina Brazil

1% A Warning: If you add a default premium to the risk premium.K. Riskfree Rate The long-term government bond rate is the appropriate riskfree rate. At the same point in time.25% = 6.00%.10 at the end of 1994.50% at the same point in time ñ Cost of Equity (British Pounds) = 8.5% + 1. The same estimation can be done in British Pounds.5% + 2.05% This is the cost of equity. if cash flows are estimated in dollars.25% 5.25% 5.55% This difference reflects differences in expected inflation in the two markets. II.10 (5.5% + 1.5% = 7% 5. using the long term Government Bond rate in the U. Illustration 3: Using the CAPM to calculate cost of equity Glaxo Holdings had an estimated beta of 1.10 (5.75% = 6.50%) = 14.5% + 0.65. Which beta would you use in valuing Glaxo? .Chile Columbia Mexico Paraguay Peru Uruguay AA A+ BBB+ BBBB BBB 5. the thirty-year treasury bond rate in the United States was 8.5% + 1. When the long term government bond rate is not available.6% = 7. y Wellcome is planning an acquisition of Glaxo.00% + 1. That would be double counting. which was 8.5% + 1. it may make sense to look at the rate at which large corporations can borrow in the local market. do not add a risk premium to the risk free rate. Wellcome has a beta of 0.50%) = 14..5% = 8% 5.75% 5. The estimated cost of equity for Glaxo in December 1994 was ñ Cost of Equity = 8.50% + 1.75% = 7.

. Thus cyclical firms can be expected to have higher betas.) These firms will have higher betas than other firms which have more traditional cost structures. (Wellcome is a good example. than non-cyclical firms. Financial Leverage: * An increase in financial leverage will increase the equity beta of a firm.Determinants of Betas I. the beta of debt is zero. (Synergen. * If all of the firm's risk are borne by the stockholders. either through acquisitions or through projects.) III.e. i. Levered Beta = Unlevered Beta (1 + (1-t) (D/E)) . and is usually defined in terms of the relationship between fixed costs and total costs. then. and debt has a tax benefit to the firm. Biotechnology firms have an average beta of 1. or because of the nature of their business. had a beta of 1. * A firm which has high operating leverage -> higher variability in earnings before interest and taxes (EBIT) -> higher beta y Sticking again with pharmaceutical firms. there are some firms which have very high fixed costs. either because they focus heavily on research. Type of Business: * The more sensitive a business is to market conditions. other things remaining equal.8. It had research and development expenses which were 670% of sales in 1994.65 in 1994. * The beta of a firm is the weighted average of the betas of its different business lines. What would the impact of these actions be on pharmaceutical firmsí betas? II. for instance. Degree of Operating Leverage: * DOL is a function of the cost structure of a firm. y Pharmaceutical companies are increasingly looking at expanding into biotechnology. the higher is its beta.

00 0.20 0.10 0. The private firm had a debt/equity ratio of 30%. t = Corporate tax rate D/E = Debt/Equity Ratio Illustration 4: Effects of Financial Leverage on Betas Glaxo. Using comparable firms: * Use the betas of publicly traded firms which are comparable in terms of business risk and operating leverage.90 1. had a debt/equity ratio of 4% in 1994.45 1.20 0.where. its beta would be much higher (Tax rate was 30%) ñ Current Beta (Levered) = 1.10 Unlevered Beta = 1. Illustration 5: Using comparable firms to estimate betas Assume that you are trying to estimate the beta for a private firm that is in the business of manufacturing. The betas of publicly traded firms involved in office equipment and supplies are as follows (They face an average tax rate of 40%).7*0.10.04) = 1.7*0.10 /(1+0. If Glaxo were to raise its debt/equity ratio to 20%. with a beta of 1.97 Debt/Equity 0.2) = 1.07 New Levered Beta = 1.03 0.17 . selling and servicing fax machines. Firm General Binding Hunt Manufacturing Moore Coroporation Nashua Company Pitney Bowes Average Beta 1.05 0.07 (1+0. * Correct for differences in financial leverage between the firm being analyzed and the comparable firms.22 Other approaches to estimating Betas I.95 0.80 0.

3)) = 1. coefficient of variation in operating income.Unlevered Beta of office supply firms = 0.00001 Total Assets where.88 (1 + (1-0.30 Growth in Earnings per share = 0.9832 + 0.0. with the following financial characteristics (defined consistently with the regression): Coefficient of Variation in Operating Income = 2. size.08 CV in Operating Income .2 Dividend Yield = 0. * Income statement and balance sheet variables are important predictors of beta * Following is a regression relating the betas of NYSE and AMEX stocks in 1991 to five variables .17)) = 0.034 Growth in Earnings per Share .15 Debt/Equity Ratio + 0.0.126 Dividend Yield + 0.88 Beta for private firm involved in office supplies = 0.4) (0.04 II.dividend yield.04 Debt/Equity Ratio = 0. debt/equity and growth in earnings. BETA = 0.97 / (1 + (1-0. .4) (0. Using fundamental factors: * Combines industry and company-fundamental factors to predict betas. CV in Operating Income = Coefficient of Variation in Operating Income = Standard Deviation in Operating Income/ Average Operating Income Illustration 6: Using fundamental information to predict betas Assume that you are trying to estimate the beta for a private firm.30 Total Assets = $ 10.000 (in thousands) The estimated beta for this firm.

Riskfree rate = 3.Rf = Risk premium per unit of factor j risk k = Number of factors Using the Arbitrage Pricing Model Illustration 7: Using the APM to estimate the cost of equity Assume that the parameters for the arbitrage pricing model have been estimated.BETA = 0. where. If these factor-specific betas and the factor risk premia can be estimated.19 The Arbitrage Pricing Model * Logic behind the arbitrage pricing model (APM) same as the logic behind the CAPM.00001*10.034 * 0. the cost of equity can also be estimated.9832 +0. i. is not a single factor but is determined by an asset's sensitivity to various economic factors that affect all assets.e.30 + 0.04 + 0.126* 0. * Measure of this non-diversifiable risk in the APM. with a beta specific to each factor. Rf = Riskfree rate Fj = Beta specific to factor j E(Rj) .2 . and that there are three factors.30 .0.5% : Risk Premium for factor 3 Assume that the betas specific to each of these factors are estimated for Pepsi Cola in 1992 and .08*2.0.. however.Rf = 4% : Risk Premium for factor 2 E(R3) .Rf = 1. * The number and the identity of the factors are determined by the data on historical returns.Rf = 3% : Risk Premium for factor 1 E(R2) . * The arbitrage pricing model relates expected returns to economic factors.000 = 1.15* 0. investors get rewarded for taking on non-diversifiable risk.35% E(R1) .

These variables can then be correlated with returns to come up with a model of expected returns. shifts in the term structure. * The biggest intuitive block in using the arbitrage pricing model is its failure to identify specifically the factors driving expected returns. . unanticipated inflation and changes in the real rate of return.1 (1. Roll and Ross (1986) suggest that the following macroeconomic variables are highly correlated with the factors that come out of factor analysis -. where there is only one underlying factor and that underlying factor is completely measured by the market index. tend to have low CAPM betas. changes in default premium. Example: Oil companies.20 F2 = 0.90 F3 = 1.10 Substituting into the APM. * Costs of going from the arbitrage pricing model to a macro-economic multi-factor model can be traced directly to the errors that can be made in identifying the factors. but it will underperform the richer APM when the company is sensitive to economic factors not well represented in the market index. Chen.35% + 1. as will the risk premia associated with each economic factor. the CAPM has the advantage of being a simpler model to estimate and to use. * In general.20% Considerations on the use of the APM * Capital asset pricing model can be considered to be a specialized case of the arbitrage pricing model. * The factors in the model can change over time. which derive most of their risk from oil price movements. Multi-factor Models for risk and return * Unidentified factors in the arbitrage pricing model are replaced with macro-economic variables. * For example. with firm-specific betas calculated relative to each variable.industrial production.5%) = 12.90 (4%) + 1.20 (3%) + 0.that the estimates are as follows: F1 = 1. Cost of Equity = 3.

The estimated growth rate in dividends is 5.82 and the stock traded at $66 in December 1992. P0 = Price of the stock today DPS1 = Expected dividends per share next year ke = Cost of Equity g = Growth rate in dividends (steady state) A simple manipulation of this formula yields. that equity is fairly valued. Illustration 8: Using the Dividend Growth Model to estimate the cost of equity: Southwestern Bell In 1992. it is inappropriate to use this approach to value stock in a firm. Southwestern Bell paid dividend per share of $2. since the current price is a key input to the model.98 Cost of Equity = $2. ke = DPS1 / P0 + g = Expected Dividend Yield + Growth rate in earnings/dividends More importantly. the present value of a share of equity can be written as: Po = Present Value of expected dividends = DPS1 / (ke . using this cost of equity. There is a strong element of circular reasoning involved that will lead the analyst to conclude.5% .g) where. Dividend Growth Model For a firm which has a stable growth rate in earnings and dividends.82 *1.5% and the firm is assumed to be in steady state. The dividend growth model can then be used to estimate the cost of equity.* Using the wrong factor(s) or missing a significant factor in a multi-factor model can lead to inferior estimates of cost of equity.055 = $2.98 / $66 + 5. Expected Dividends in 1993 = $2.

Tax rate=30%) * Equity comprised 85. . This results in Cost of equity = 8. Value of Equity = $ 2.055) = $66 Not surprisingly.98 / (.10 . (Pre-tax cost of debt=9.30%. WACC = Weighted Average Cost of Capital ke = Cost of Equity kd = After-tax Cost of Debt kps = Cost of Preferred Stock E/(E+D+PS) = Market Value proportion of Equity in Funding Mix D/(E+D+PS) = Market Value proportion of Debt in Funding Mix PS/(E+D+PS) = Market Value proportion of Preferred Stock in Funding Mix Illustration 9: Calculating the Cost of Capital: Genzyme Corporation.60 (5.00%+1.50%) = 16.80% * an after-tax cost of debt of 6.00% (in market value terms) of the funding mix and debt made up the remaining 15..00%. WACC = ke ( E/ (D+E+PS)) + kd ( D/ (D+E+PS)) + kps ( PS/ (D+E+PS)) where. In December 1994.60.= 10% To illustrate the circular reasoning involved in using this cost of equity to value stock.00%. Weighted Average Cost of Capital (WACC) Definition of the Weighted Average Cost of Capital (WACC) The weighted average cost of capital is defined as the weighted average of the costs of the different components of financing used by a firm. Genzyme Corporation had * a beta of 1. the stock is found to be fairly valued.

* The cost of capital for Genzyme can then be calculated as follows: WACC = 16.Working Capital Needs .Principal Repayments + Proceeds from New Debt Issues = Free Cash flow to Equity Levered Firm at Desired Leverage Net Income .85) + 6.Taxes = Net Income + Depreciation & Amortization = Cash flows from Operations .Capital Expenditures .Depreciation & Amortization = Earnings before interest and taxes (EBIT) .80% (0.Interest Expenses = Earnings before taxes .15) = 15.Operating Expenses = Earnings before interest.30% (0.23 % ESTIMATION OF CASH FLOWS Cash flows to Equity for a Levered Firm Revenues . taxes and depreciation (EBITDA) .Preferred Dividends .

(How does one know?) The company reported net income of $695 million in 1994 and is projected to have a net income of $765 million in 1995.56 Estd 1995 $ 765.50 14%) $ 572. Thus FCFE will be an increasing function of _.50 $ 172. This debt ratio is assumed to be stable. and sales are expected to increase from $6420 million in 1994 to $7100 million in 1995. The company had capital expenditures of $362 million in 1994 and is expected to have capital expenditures of $400 million in 1995.DR) Working Capital Needs = Free Cash flow to Equity For this firm.. leading to a debt to capital ratio (ìdebt ratioî) of 14%.(1.Depreciation) (1-DR) .00 (DR = 14%) (DR = $ 20. y y y y y The company had $1.DR) (Capital Expenditures . The companyís working capital increased to $225 million in 1994 from $203 million in 1993.(1.52 $ 18.( Change in Working Capital) (1-DR) FCFE Proposition : The Free Cash Flow to Equity will increase as the amount of debt financing used by the firm increases. .Depreciation) .92 $ 519. The company reported depreciation of $180 million in 1994 and is expected to have depreciation of $200 million in 1995.(Cap Ex .5 billion in debt outstanding and $ 9 billion in market value of equity.00 $ 156. It is expected to maintain working capital at the same percentage of sales in 1995. Proceeds from new debt issues = Principal Repayments +DR (Capital Expenditures Depreciation + Working Capital Needs) Illustration 10: Estimating the cash flow to equity for a firm at its desired leverage: WarnerLambert The following is an estimation of free cash flows to equity for Warner-Lambert in 1994 and for 1995 (projected).00 Net Income . 1994 $ 695.

20 $ 14.00 (1-DR) 40%) .Illustration 11: Sensitivity to Debt Ratio .Capital Spending .( Change in Working (DR = $ 13.Warner Lambert Corporation The following are the cash flows to equity for Warner Lambert.60 $ 630.Change in Working Capital .00 $ 765. using a debt ratio of 40% instead of a debt ratio of 14%.tax rate) + Depreciation .20 $ 120.(Cap Ex .Depreciation) (DR = $ 109.00 .70 The following graph illustrates the effect on free cash flows to equity of changing the debt ratios from 0% to 100% ñ CASHFLOWS TO THE FIRM EBIT ( 1 .30 Capital) (1-DR) 40%) FCFE $ 572. 1994 Estd 1995 Net Income $ 695.

Siemens Siemens AG. in real terms.613 mil DM 4. as a German-based multinational involved in a wide range of businesses. It had depreciation of 4. at 5% a year for the next three years and 3% a year after that.159 mil DM 2. the working capital increased from 14.Bond rate is 6.098 mil DM 770 mil DM Free Cashflow to firm 114 mil DM 696 mil DM INFLATION AND VALUATION Consistency Principle 1: Nominal cash flows should be discounted at nominal discount rates. 1992 Projected 1993 EBIT (1 . In addition. prior to general provisions and extraordinary charges.560 mil DM 5. The valuation of this firm can be done on either a real or a nominal basis: The estimates of growth on a real and nominal basis are done first . The free cashflows to the firm for 1992 and 1993 (estimated) are provided below.tax rate) 2. depreciation and working capital are all expected to increase by 5% in 1993.460 mil DM + Depreciation 4.Change in Working Capital 1.560 million DM in 1992.= Cash flow to the firm Illustration 12: Estimating the expected cash flow to the firm .613 million DM and capital expenditures of 5.967 million DM in 1993. The firm has a beta of 1. Real cash flows should be discounted at real discount rates. reported earnings before interest and taxes of 3.838 mil DM . The firm had a tax rate of 38% in 1992. Capital expenditures.482 million DM in 1992.Capital Expenditures 5.844 mil DM .405 million DM in 1992.0 and the current T.306 million DM in 1991 to 15. The earnings before interest and taxes is expected to increase to 3. The expected inflation rate is 3% in both the firm's cash flows and the general economy.5%. Illustration 13: The Effect of Inflation on Cash flows and Discount Rates Consider a firm which has cash flows to equity currently of $100 million and is expected to grow.

09% The discount rate can similarly be estimated on a real and nominal basis: Real Nominal Discount Rate 1. Using these growth rates the cash flows can be generated in both nominal and real terms: Real Cash flows Nominal Cash flows Terminal Nominal Cash Terminal Year CF to Equity Value flows Value 1 $105 $108 2 $110 $117 3 $116 $2.5%) =12% The expected nominal return is estimated using the CAPM..271) / 1.5%..271 The terminal values are calculated as follows for real and nominal cash flows: Terminal value (Real Cash flows) = $ 116 * 1.12 .078 Terminal value (Nominal Cash flows) = $ 126 * 1.12 + $ 117 / 1.03 -1 = 8.896 Illustration 13A: The Effect of mismatching cash flows and discount rates Real Cash flows@ Nominal Nominal Cash flows@ Real rate rate .123 = $ 1.05)(1.896 Present value (using nominal cash flows) = $108/1.Real Nominal Growth Rate in first 3 years 5% (1.03 / (. with a historical premium earned by stocks over T.078) / 1.5% +1(5.0609 / (.078 $126 $2.12/1.271 This calculation assumes that the growth rates after year 3 are steady state growth rates and will continue through infinity.08742 + ($116 + $2.74% E(R) =6.0874 .03) = $ 2. The present values of the cash flows to equity and the terminal value can then be calculated using the appropriate discount rate: Present value (using real cash flows) = $105/1.03)-1 = 8.03)(1.15% Growth Rate after year 3 3% (1.03)-1 = 6.08743 = $ 1.0609) = $ 2.0874 + $ 110 / 1.Bonds of 5.122 + ($126 + $2.

068) / 1. After-tax version of the Capital Asset Pricing Model E(Rj) = Rf + H+ HFj + H2 (Kj .293 > True value of $1.068 If real cash flows are discounted at the nominal discount rate.08742 + ($126 + $5. E(Rj) = Expected pre-tax return on asset j Rf = Riskfree rate Fj = Beta of asset j .Rf) where.896 TAXES AND VALUATION Consistency Principle 2: Pre-tax cash flows should be discounted at pre-tax discount rates. Terminal value (using nominal rate and real cash flows) = $ 116 *1.03 / (.12 + $ 110 / 1.0609) = $ 5. the present value is: Present value (nominal cash flows discounted at real rates) = $108/1.325) / 1.325 Terminal value (using real rate and nominal cash flows) = $ 126 * 1.0874 -.123 = $ 1.Year CF to Equity 1 2 3 $105 $110 $116 Terminal Value $1. the present value is: Present value (real cash flows discounted at nominal rates) = $105/1.122 + ($116 + $1.03) = $1.068 The terminal values are miscalculated because cash flows and discount rates are not matched.207 < True value of $1.0874 + $ 117 / 1.896 If nominal cash flows are discounted at the real discount rate.325 Nominal Cash flows $108 $117 $126 Terminal Value $5.08743 = $4.12-. After-tax cash flows should be discounted at after-tax discount rates.0609 / (.

56 3 $2.79 4 $3.12933 + $3.12934 + ($3.05 5 $3. The following example values Eli Lilly on the basis of cash flows after personal taxes for an investor with a tax rate of 40% for ordinary income and 28% for capital gains.1293 + $ 2.60 / 1.($93.41 The discount rate before personal taxes can be apportioned into dividend yield and price appreciation: .60 $1.Ordinary tax rate) Terminal price after taxes = Terminal price before taxes .20 The initial price is assumed to be $62.43 .Initial price) * Capital Gains tax rate = $ 93.91+$93.(Terminal price .93% Present Value per share (based upon pre-tax cash flows and pre-tax discount rates) =$ 2.12932 + $2.20) * 0.15%.15% + 1.5%) = 12.27/1.Kj = Dividend Yield of asset j H0 = A constant term H1 = Market premium for systematic risk H2 = Influence of dividend payout on expected returns Illustration 14: Effect of personal taxes on cash flows and discount rates: Eli Lilly The expected dividends and the terminal price were estimated for Eli Lilly at the beginning of 1992 for the next five years (before personal taxes). The firm had a beta of 1.41 The discount rate can be estimated before personal taxes and used to calculate the present value per share: Discount rate before personal taxes = 7.12935 = $ 62.91 $93.$62.98/1.20.45)/1.43 $2.98 $1. The cash flows after personal taxes are estimated after personal taxes as follows: Dividends per share after taxes = Dividends per share before taxes * (1 .35 $84.28 = $84.41/1. The cash flows on a pre and post tax basis are as follows: Before personal taxes After personal taxes Dividends per Terminal Dividends per Terminal Year share price share price 1 $2.36 2 $2.27 $1.43 .05 (5.05 and the treasury bond rate wass 7.41 $2.

02% 12.Expected Dividend Yield = Expected Dividends next year/ Initial Price =$2.0.39% . starting in 1989 and ending in 1994: Year 1989 1990 1991 1992 1993 1994 EPS $0.0886 + $ 1.20 Thus the value is unaffected by whether cash flows are before or after personal taxes.Expected Dividend Yield = 12.93% .91 $1.08865 = $ 62. the following factors have to be considered o how to deal with negative earning o the effect of changing size Illustration 15: Using arithmetic average versus geometric average: Autodesk The following are the earnings per share at Glaxo Pharmaceuticals.56 / 1.56% -11.71% Expected Price Appreciation = Expected Return .22% Discount rate after personal taxes = 3.20 = 3.27 Growth Rate 36.41)/1.28) = 8.22% (1 .13 $1.71% (1 .11% 39.3.36% 1.27 / $62.05/1. ESTIMATING GROWTH RATES I.40) + 9.08863 + $2.90 $0.27 $1. Estimating and Using Historical Growth Rates y y y Historical growth rates can be estimated in a number of different ways o Arithmetic versus Geometric Averages o Simple versus Regression Models Historical growth rates can be sensitive to o the period used in the estimation In using historical growth rates.66 $0.08862 + $1.36/1.35+$84. as long as the discount rates are adjusted accordingly.08864 + ($2.71% = 9.0.79/1.86% Present Value per share (based upon after-tax cash flows and after-tax discount rates) =$ 1.

81% Illustration 17: Linear and Log-linear models of growth: Glaxo Inc.65 $0. Time (t) 1 2 3 4 5 6 7 Year 1988 1989 1990 1991 1992 1993 1994 EPS $0.27 $1.91 $1.Arithmetic mean = (36.12 0.24 Linear Regression : EPS = 0.42 -0.27 $1.99% Illustration 16: Sensitivity of historical growth rates to the length of the estimation period: Glaxo The following table provides earnings per share at Glaxo.68% Geometric mean = (1.66)1/5 -1 = 13. The earnings per share from 1988 until 1994 is provided for Glaxo.27/0.36%+1. starting in 1988 instead of 1989 and uses six years of growth rather than five to estimate the arithmetic and geometric averages.65)1/6 -1 = 11.39%)/5 = 15. and the linear and log linear regressions are done below: Time (t) 1 2 3 4 5 6 7 Year 1988 1989 1990 1991 1992 1993 1994 EPS $0.13 $1.09 0.27/0..24 0.11 -0.13 $1.91 $1.56%-11.27 ln(EPS) -0.66 $0.90 $0.32% Geometric mean = (1.90 $0.65 $0.02%+12.43 -0.5171 + 0.11%+39.66 $0.1132 t .27 Arithmetic average = 13.

06% -88.34 -1.27 2 1989 $1. the traditional growth rate measures would be ñ Arithmetic Growth Rate = = EPSt/EPSt-1 -1 = $1.00% 225.00% .00> .1 = -200 % Geometric growth rate = $1.06% 6 1993 ($0.00/<$1.55% -39. Modified growth rate =(EPSt-EPSt-1)/Max(EPSt.1225 (8)) = $ 1.57 -50.Log-linear Regression: ln (EPS) = -0.08 129.42 Expected EPS (1995): log-linear regression = e (-0.00> = -100% There is a solution to this problem.55536 + 0.38% 5 1992 $0. if earnings per share goes from <$1.40 -37.00% 7 1994 $0.07 0.53 Dealing with negative earnings Calculating growth rates when earnings become negative is problematic.77 0.00> to $1. since the traditional growth rate measures often fail.1225 t Expected EPS (1995) : linear regression = 0.28% 3 1990 $1.10) NMF -225. The following series lists earnings per share from 1988 to 1994 for Sterling Chemicalsñ Growth Modified Time (t) Year EPS log(EPS) Rate Growth Rate 1 1988 $3.56 1.67 -0.07 -39.1132 (8) = $1.41% 440.00/<$1.5171 + 0.5536 + 0.55% 4 1991 $0.00.38% -37.08 -2.28% -50.53 -88. For instance.EPSt-1) Illustration 18: Dealing with negative earnings: Sterling Chemicals.

32 86.72% $48.291.5139 / 1. % Growth Æ Net Year Net Income Rate Income 1989 $19. but do not do much better than such models over the long term.67 86.30 116. Analystsí Forecasts Of Earnings: How Good Are They? Studies indicate that analysts do better than mechanical models at forecasting earnings in the short term.42% $4.42% $692.63 86.16% $75.42% Assuming that this growth rate continues for the next five years.20 351.5139 t Average EPS (1988-94) = $ 1.10 1992 $306.63% $120.494.13% $100.407.35 1998 $5.10 1990 $86.72 1997 $2.98 86.192.487.10 Geometric Average Growth Rate = 86.0.10 1991 $186.42% $2. % Growth Æ Net Year Net Income Rate Income 1995 $801. .1114 .06 Growth rate = . The following table shows the growth in net income for Amgen from 1989 to 1994.785.20 1994 $430. using modified growth rates = .60 86.70 64.31 1999 $9.00 21.40 1993 $354.48% Approach 2: Using the minimum or maximum of earnings as the denominator Arithmetic average.51.31% $67.60 1996 $1.1 million in 1989 to $430 million in 1994.65 II.90 15.06 = -48.42% $1.0.680.Approach 1: Using the slope coefficient from the linear regression EPS =3.42% $371. in both percentage and dollar terms.81% Illustration 19: The Effect of size on growth: Amgen Amgen increased its net income from $19.

and they continue to rise in the following period (2. 4.8% for the sells).8% 1969-79 Are some analysts more equal than others? Some analysts are better at predicting earnings than other analysts.2% 1972-75 Fried & Givoly Earnings Forecaster 16.1% 1970-74 Brown & Rozeff Value Line Forecasts 28. The recommendations made by the ëbestí analysts (Institutional Investorís All American Analysts) have a greater impact on stock prices (3% on buys.Mean Relative Absolute Error Study Analyst Group Analyst Mechanical Forecasts Models Collins & Hopwood Value Line Forecasts 31.4% 19.4% 32. III. The prices tend to drift back to their original levels. They are also usually better at picking stocks.7% on sells). analysts affect stock prices with their recommendations.7% 34. Buy recommendations affect prices less than sell recommendations.4% for buys. For these recommendations the price changes are sustained. 13. Expected Growth And Fundamentals Retention Ratio and Return on Equity gt = Retained Earningst-1/ NIt-1 * ROE = Retention Ratio * ROE = b * ROE . Studies examining how effective analysts are conclude the following ñ y y On average.

0% 25.i (1-t)) . ROE and Leverage ROE = ROA + D/E (ROA .52*0.00% 52% Return on Equity 26.26)/3010) = 13.52*0. If the ROE drops by 2% the expected growth rate in 1995 would be 4.ROEt-1) / NIt-1]+ b * ROE Illustration 20: Changes in ROE and growth rates: Merck Inc.5% Growth Rate = 0.72%.Proposition 1: The expected growth rate in earnings for a company cannot exceed its return on equity in the long term.52% + 0.20%. 1994 1995 BV of Equity 11700 Net Income 3010 Retention Ratio 52. The following table provides information on the retention ratio and the return on equity for Merck for 1994 and projections for 1995. The relationship between growth rates and changes in return on equity is as follows ñ gt = [BV of Equityt-1 * (ROEt .255 = 11.32% A drop in the return on equity of 0.5% translates into a drop in the growth rate of 2.26 = (11700*(.255-. Short term changes in ROE Small changes in return on equity can lead to large shifts in the growth rate for some firms.

The following table provides projections in profit margins.80 . Return on Assets. The pre-interest. after-tax profit margin is expected to drop from 7. ROA = (Net Income + Interest (1 .6851 1. asset turnover and growth rates after the shift in corporate strategy: 1992 After shift in strategy EBIT (1. after-tax profit margin 7.362 Pre-interest.t) / BV of Total Assets D/E = BV of Debt/ BV of Equity i = Interest Expense on Debt / BV of Debt t = Tax rate on ordinary income Note that BV of Assets = BV of Debt + BV of Equity. Profit Margin and Asset Turnover ROA = EBIT (1-t) / Total Assets = [EBIT (1-t) / Sales] * [Sales/Total Assets] = Pre-interest profit margin * Asset Turnover Illustration 22: Evaluating the effects of corporate strategy on growth rate and value: Procter and Gamble Procter & Gamble decided to reduce prices on their disposable diapers in April 1993 to compete better with low-price private label brands.6851 to 1.43% 7.00% Total Assets $17.tax rate) $ 2181 Sales $ 29.424 Asset Turnover 1.43% to 7% as a consequence and the asset turnover is expected to increase from 1.where.80.tax rate)) / BV of Total Assets = EBIT (1.

30 20.5% 15% Debt/Equity 0% 25% Interest rate on debt 10% 8.a software company. The following table provides estimates of return on assets. Neutrogena is expected to grow at an extraordinary rate in the first five years (growth phase) and at a stable rate after that (steady state).31 0.74% Illustration 23: Adjusting inputs for firm type: Neutrogena Inc. a cosmetics manufacturer.42% 1991 $2.52% 12.69% 1989 $1.48% 1990 $2. Consider Autodesk Inc.00% Growth Rate 14. with earnings per share available from 1987 to 1992.375% Illustration 24: Weighting based upon standard deviations: Autodesk Inc.29% Analyst Number 1 2 3 4 5 6 7 Estimated Growth 10.89 1988 $1. Growth phase Steady State Retention Ratio 76% 50% Return on Assets 19.00% Debt/Equity 0.7108 0.50% 12.91 41.00% 12.66% 10. retention ratio and interest rates for Neutrogena.43% 1992 $1. Historical EPS Analyst Estimates Growth Year EPS Rate 1987 $0.7108 Interest rate on debt (1 . The following table also provides analyst forecasts of expected growth over the next five years from nine analysts following Autodesk.00% 10.82% 8.60% Retention Ratio 58.35 51.00% 16.27% Growth Rate 10.00% .00% 58.tax rate) 4.Return on Assets 12.00% 16.50% 13.27% 4.98 -14.

8 18.00% Arithmetic mean = 19.49% Standard Deviation = 3.95% Consensus Forecast = 14% Standard Deviation = 27.45% .

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